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Cyprus Bailout Shuts Bank

Nation will shrink its banking sector in exchange for 10 billion euros in aid.

Cyprus dodged a disorderly default and unprecedented exit from the euro by bowing to demands from creditors to shrink its banking system in exchange for 10 billion euros ($13 billion) of aid.

Cypriot President Nicos Anastasiades agreed to shut the country’s second-largest bank under pressure from a German-led bloc in a nighttime negotiating melodrama that threatened to rekindle the debt crisis and rattle markets.

It was the second time in nine days that Cyprus struck a deal with its euro partners and the International Monetary Fund, capping a tumultuous week that underscored the contradictions of the crisis management that has dominated European policy making for more than three years. Cyprus, the euro area’s third-smallest economy, is the fifth country to tap international aid since the crisis broke out in Greece in 2009.

The first Cypriot accord, reached March 16, fell apart three days later when the parliament in Nicosia rejected a key plank, a tax on all bank accounts that sparked the indignation of smaller depositors. Efforts to win an alternative bailout from Russia, which lent Cyprus 2.5 billion euros in 2011 when the nation was shut out of international markets, failed.

“Nobody knows where we are heading,” said Epifanos Epifaniou, 50, who used to drive a delivery truck in Nicosia and has been unemployed for six months. “People are playing games with Cyprus. We are alone. Nobody is supporting us.”

The euro strengthened, trading 0.2 percent higher against the dollar at $1.3018 as of 11:03 a.m. in Frankfurt. Stocks gained, with the Stoxx Europe 600 Index rising 0.9 percent. Italian 10-year bonds erased their decline since last month’s inconclusive election.

German Finance Minister Wolfgang Schaeuble told reporters today the agreement was “capable of stabilizing the situation in Cyprus.” Hans Michelbach, a German lawmaker and ally of Chancellor Angela Merkel, said he was “cautiously relieved.” Last week, Michelbach said Cyprus would pay a “high price” for rejecting the initial deal.

Bartering

The breakthrough came when Anastasiades bartered with officials including EU President Herman Van Rompuy, European Central Bank President Mario Draghi and IMF Managing Director Christine Lagarde. It was then sealed by the finance ministers, some of whom went out to dinner while the talks were ongoing.

With the ECB threatening to cut off emergency financing for tottering banks as soon as today, Cyprus’s leaders engineered another way of shrinking the island’s financial system.

The revised accord spares bank accounts below the insured limit of 100,000 euros. It imposes losses that two EU officials said would be no more than 40 percent on uninsured depositors at Bank of Cyprus Plc, the largest bank, which will take over the viable assets of Cyprus Popular Bank Pcl, the second biggest.

Cyprus Popular Bank, 84 percent owned by the government, will be wound down. Those who will be largely wiped out include uninsured depositors and bondholders, including senior creditors. Senior bondholders will also contribute to the recapitalization of Bank of Cyprus.

The squeezed banking industry will likely lead to a “sharp drop” in Cyprus’s gross domestic product this year and next, according to Reinhard Cluse, a London-based economist at UBS AG. As a result, the euro group’s debt-to-GDP ratio target of 100 percent by 2020 “must be doubted,” he said.

The Cypriot Finance Ministry said in a January presentation that bailing out the country may push debt to a peak of about 140 percent of GDP next year.

“Cyprus’s sovereign debt problems will remain an issue of concern -- for European policy makers and for the markets,” Cluse wrote in a note to clients today.

Banks in Cyprus, which have been shut for the past week, will remain closed until further notice. Lawmakers in Cyprus voted last week to impose capital controls to prevent a run on deposits when they reopen.

The union representing Cypriot banking workers said today the Mediterranean island is faced with a “painful compromise,” according to a statement posted on its website. It urged employees to be ready to return to work when banks reopen.

Better Solution

“This solution we reached tonight doesn’t have the downsides that the solution of last week did,” said Dutch Finance Minister Jeroen Dijsselbloem, chairman of the euro ministers’ panel. He said the deal was beyond the range of “political possibilities” a week ago.

The Cypriot parliament won’t have to vote again because it has already passed laws on bank restructuring, officials said. On the creditors’ side, legislatures in Germany, Finland and the Netherlands may hold votes to approve loans to Cyprus from the European Stability Mechanism, the 500 billion-euro rescue fund.

Klaus Regling, managing director of the rescue fund, said approval by creditor governments in mid-April will pave the way for the first payouts to Cyprus in early May.

Lagarde said she will recommend that the IMF provide loans, without giving a figure. “There might have been a bit of friction here and there,” she said.

The next step lies with the ECB, which needs to keep funds flowing to solvent Cypriot banks to enable them to open. While Draghi and Executive Board member Joerg Asmussen left Brussels without commenting to reporters, a statement by the ministers said the bank will channel liquidity to the Bank of Cyprus “in line with applicable rules.”

The seizure of larger deposits may spark tensions with Russia, the source of an estimated $31 billion in holdings in Cypriot banks, according to Moody’s Investors Service. A Cypriot mission to Moscow last week failed to yield an alternative to the European-sponsored bailout.

The effort to go after insured deposits, while abandoned, may have harmful repercussions, said Moody’s in a note early today. “Policy makers’ recent decisions raise the risk of deposit outflows, capital flight, increased bank and sovereign funding costs and broader financial-market dislocation throughout the euro area in the future,” Moody’s said.

In a replay of tensions over aid for Greece at the outset of the crisis, European governments had wrangled over aid for Cyprus for nine months, exposing holes in the revamped economic management system that was built in three years of emergency policymaking, often at all-night summits.

A tightening of Europe’s budget-deficit restrictions and new rules to penalize countries with unbalanced economies or asset bubbles failed to stop the rot in Cyprus, which makes up less than 0.2 percent of euro-region output.

Hundreds of protesters massed outside the floodlit presidential palace in Nicosia late yesterday, one group brandishing a banner that said: “It’s capitalism, stupid.”

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